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The International Capital Market Association, the trade association for investment banks, has warned that bans on naked short selling of government bonds could have a negative impact on liquidity in the region’s market for repurchase agreements, the importance of which was brought into sharp focus during the financial crisis.

The European Repo Council, part of ICMA, this morning published a white paper in which it argues moves by Germany in May to ban naked short selling of government bonds might have far reaching "unintended consequences" for the repo market. France has also said it is supporting a wider ban.

ICMA argues liquidity in the repo markets could be impacted by the short-selling ban, saying they would increase costs and risks for issuers and investors by restricting their ability to hedge through the repo markets. There is a distinction between speculative short selling and covering positions, and often that is not clear in regulatory language.

The report said: “Short-selling is a fundamental trading technique which performs an essential function in the markets, among other things, supporting market-making in government securities.”

Repurchase agreements are contracts between two parties where one sells the other a security at a specified price with a commitment to buy it back at a later date for another specified price. Most repos are overnight transactions, with the sale taking place one day and being reversed the next day.

The market came into the spotlight when banks used central bank facilities to clear assets off their balance sheets in response to the financial crisis, as central banks eased requirements for assets to be included in their schemes and allowing banks to raise much needed cash.

Globally, the repo market is worth an estimated $30 trillion (€23 trillion), according to ICMA. The European market is worth €5.6 trillion. It is also dominated by trading in government bonds , which make up around 80% of the total market .

The problem, as far as the regulators are concerned, comes from trades in government bonds where one party has an obligation to deliver a bond without holding it before making the trade – these trades are prohibited when a naked short-selling ban is in place.

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Although aimed at speculators making concerted attacks on European government bonds such as Greece, such moves could restrict trading activity in the repo markets, regardless of the intention of the trader, causing fewer people trade the securities for fear of falling foul of the new rules.

However, Godfried De Vidts, chairman of the European Repo Council , said: "We as market participants are best placed to assure the proper working of the repo market, and from the data we have gathered there is no conclusive proof that there is a problem with short selling in the repo market."

Senior visiting fellow at the Icma Centre Richard Comotto , who wrote the white paper, added that cases of naked shorting in the repo markets can be dealt with under the existing Market Abuse directives, rather than bringing in new rules to limit or ban these positions.

He said: "That would enable regulators to deal with the pattern of behaviour underlying such activities, for example planting rumours in the market, and would have the effect of punishing the individual rather than the market. A sensible approach would to monitor and assess the extent of short selling in the market in the first instance."